A disability buy-sell agreement is a contract between the co-owners of a business that sets, in advance, the price, funding source, and timeline for buying out an owner who becomes too disabled to keep working. It exists so a disability does not freeze the company: without one, a disabled owner’s interest can sit in limbo for years, producing deadlocked votes, frozen accounts, and litigation that drains the business. The document is only as strong as its specifics. The definition of disability, the waiting period, the valuation method, the funding source, and the tax structure all have to fit together, because any gap between them turns into a fight at the worst possible moment.
One boundary worth naming up front: this is not the same product as personal disability income insurance. Personal coverage replaces a portion of an owner’s lost wages so the household keeps running. A disability buy-sell, and the buy-out insurance that typically funds it, pays the purchasing party so the ownership interest actually changes hands. Most owners need both.
What Counts as a Disability
The entire contract turns on how “disability” is defined. Most agreements use a total disability standard, meaning the owner cannot perform the core duties of their role in the business. That language usually mirrors the definition in the funding insurance policy, and the match matters: if the contract’s trigger fires before the insurer’s does, the buyout is owed with no money to pay it.
Some agreements also address partial disability, where the owner can still work in a reduced capacity. In that case the contract might call for a prorated buyout, or for a temporary cut in responsibilities and profit share rather than a full exit. This is a negotiation to have while everyone is healthy, not during a crisis.
Agreements should also name who decides whether the definition has been met. Common approaches include certification by the owner’s treating physician, an independent medical examination selected by the other owners or the company, or the insurer’s own determination when a buy-out policy is in force. The strongest agreements build in a tie-breaker: each side picks a physician, and those two jointly select a third whose call is binding.
The Elimination Period and What Happens During It
Every disability buy-sell includes an elimination period, a waiting phase before the buyout kicks in. It typically runs twelve to twenty-four months, and the owner must remain continuously disabled throughout. The purpose is to prevent premature ownership transfers over a broken leg or a recoverable surgery. If the owner returns to work during the window, the agreement stays dormant.
The waiting period raises practical questions that many agreements fail to answer. Does the disabled owner keep a board seat? Can they vote on major decisions? Do profit distributions continue? When the contract is silent, the default rules in the state’s business entity statute apply, and those defaults rarely match what the parties would have chosen.
Well-drafted agreements usually let the disabled owner keep their economic interest, meaning distributions and profit allocations, while suspending or limiting their management authority. That protects the disabled owner financially while letting the remaining partners run the business without deadlock.
How the Business Gets Valued
Price is where these deals fall apart most often. The agreement should lock in a valuation methodology long before anyone needs one. Several approaches are common, and each has trade-offs.
- A fixed price the owners agree on annually. Simple, but only if the parties actually update it. Most agreements include a fallback formula for when the fixed price has gone stale.
- Book value, calculated as assets minus liabilities on the balance sheet. Easy to compute, but it usually understates a profitable business because it ignores goodwill, brand value, and future earnings.
- A formula, typically a multiple of EBITDA. A business earning $500,000 in EBITDA at an agreed 4x multiple values out at $2 million. The multiplier should reflect industry norms and be revisited.
- An independent appraisal at the time of the triggering event. This produces the most defensible number but takes time and money. Formal valuation reports commonly run $5,000 to $20,000 depending on the company’s size and complexity.
Many agreements combine methods, requiring an independent appraisal if the fixed price has not been updated within, for example, eighteen months.
Extra Rules for Family-Owned Businesses
If the co-owners are family members, the IRS applies extra scrutiny to the buyout price. Section 2703 of the Internal Revenue Code allows the IRS to disregard the agreement’s stated price for estate and gift tax purposes unless the agreement is a bona fide business arrangement, is not a device to transfer property to family below fair market value, and has terms comparable to what unrelated parties would agree to at arm’s length. Failing the test means the interest can be revalued at full fair market value when estate or gift taxes are calculated, no matter what the contract says. Keeping an independent appraisal on file and updating it regularly helps satisfy these requirements.
Who Actually Buys the Shares
The agreement’s structure determines who does the buying, and the choice creates meaningfully different tax outcomes.
Cross-Purchase Agreements
In a cross-purchase arrangement, the remaining individual owners personally buy the departing owner’s interest. Each purchasing owner takes a cost basis in the acquired shares equal to what they paid, which reduces their taxable gain if they later sell the business. That basis step-up is the main tax advantage.
The downside is administrative complexity. Each owner needs a separate insurance policy on every other owner, and the count grows quickly under the formula n × (n − 1). Three owners need six policies. Five owners need twenty. Seven owners need forty-two. A trusteed cross-purchase plan can collapse this to one policy per owner by having a trust hold the policies and handle the transactions, preserving the basis benefit while keeping the paperwork manageable.
Entity Purchase Agreements
In an entity purchase (or redemption) structure, the business itself buys back the disabled owner’s interest. The company owns the insurance and uses the proceeds to retire the shares. Only one policy per owner is needed regardless of how many co-owners exist, which is simpler to run.
The trade-off is that the remaining owners do not get a basis increase in their shares. Their ownership percentages rise automatically when shares are retired, but their cost basis stays the same, producing a larger taxable gain when they eventually sell.
The Connelly Decision
The 2024 Supreme Court decision in Connelly v. United States changed the math for entity purchase agreements funded with insurance. The Court held that life insurance proceeds payable to a corporation are an asset that increases the company’s fair market value for federal estate tax purposes, and a contractual obligation to redeem shares at fair market value does not offset that increase. If the company holds a $3 million policy to fund a buyout, that $3 million is added to the company’s value when estate taxes on the departing owner’s interest are calculated.
Connelly itself involved a death-triggered buy-sell funded by life insurance, but the valuation logic applies to any scenario where the entity holds insurance proceeds earmarked for a redemption. Owners using an entity purchase structure should revisit the agreement with a tax advisor to decide whether a cross-purchase or trusteed arrangement now produces a better result.
Funding the Buyout
An agreement is only as good as its funding. Promising a $2 million buyout is easy. Having $2 million available when it is owed is the hard part.
Dedicated disability buy-out insurance is the most reliable source. These policies pay a lump sum or monthly installments directly to the party contractually obligated to buy the shares, and the payout is sized to match the agreed price. Underwriting can be a problem for older owners or those with existing health issues, so securing coverage early matters. If an owner becomes uninsurable, a backup plan is essential.
When insurance is unavailable or falls short, an installment note lets the buyer pay the disabled owner over time, typically five to ten years at a fixed rate. The interest rate must be at least the IRS Applicable Federal Rate to avoid imputed interest problems. As of early 2026, the long-term AFR (for obligations over nine years) sits around 4.5% to 4.6% annually, and the rate is updated monthly. Installments avoid draining company cash all at once, but they create ongoing pressure on the business, and the disabled owner bears the risk that future payments may not be made.
Some businesses also build a sinking fund, setting money aside in a reserve account. This works as self-insurance, but if a disability happens in year two before the fund has accumulated much, there is a gap. Sinking funds work best as a supplement to insurance, not a replacement.
Taxes the Parties Actually Feel
Premiums and Proceeds
Premiums for disability buy-out insurance are generally not tax-deductible for the business or the individual owners. The trade-off is that the proceeds are typically received free of income tax. Under Section 104(a)(3) of the Internal Revenue Code, amounts received through accident or health insurance for personal injuries or sickness are excluded from gross income when the premiums were paid with after-tax dollars. That tax-free treatment means the full payout goes toward the purchase price. Deducting the premiums instead would push the proceeds into taxable income under the Section 105/106 framework, which is why most tax advisors recommend against the deduction.
Capital Gains on the Sale
The disabled owner selling the interest owes capital gains tax on the difference between the original cost basis and the buyout price. For 2026, long-term capital gains rates are 0%, 15%, or 20% depending on taxable income. Single filers pay 15% on gains once taxable income exceeds $49,450 and 20% once it exceeds $545,500. For married couples filing jointly, the 15% rate applies above $98,900 and the 20% rate above $613,700. Most owners selling a meaningful stake will land in the 15% or 20% bracket. The 3.8% net investment income tax may also apply at higher income levels, pushing the effective rate above 20%.
S Corporation Traps
If the business is an S corporation, a poorly drafted agreement can accidentally terminate the S election. The most common risk during an installment buyout is that the promissory note gets recharacterized as a second class of stock, which violates the single-class-of-stock requirement. To avoid this, the note should qualify under the straight debt safe harbor in Section 1361(c)(5). The agreement should also prohibit transfers of shares to corporations, partnerships, ineligible trusts, nonresident aliens, or any transfer that would push the shareholder count above 100.
Section 409A and the Disability Definition
If buyout payments could be characterized as deferred compensation, Section 409A imposes strict rules on timing. The penalty for noncompliance is harsh: the full amount becomes immediately taxable, plus a 20% additional tax and interest. To use disability as a valid payment trigger under Section 409A, the agreement must use that section’s specific definition: the owner must be unable to engage in any substantial gainful activity due to a physical or mental impairment expected to result in death or to last at least twelve continuous months.
That definition is narrower than what many buy-sell agreements use. If the contract triggers at “unable to perform the duties of your occupation” while Section 409A requires “unable to engage in any substantial gainful activity,” the mismatch can create a taxable event. Having counsel cross-check the disability definition against Section 409A is one of the most cost-effective steps in drafting.
Transfer-for-Value on Insurance Policies
When insurance policies change hands, such as when an owner leaves and a policy they held on a co-owner is transferred, the transfer-for-value rule can turn otherwise tax-free insurance proceeds into taxable income. Section 101(a)(2) limits the income tax exclusion for transferred policies but carves out exceptions for transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Cross-purchase arrangements among partners generally fit within these exceptions, but the rules are technical and easy to miss when ownership structures shift.
Resolving Disputes
Litigation over a disability buyout is expensive, slow, and usually destructive to the business. Strong agreements include mandatory mediation or arbitration clauses to keep the fight out of court. Arbitration tends to be faster and cheaper than traditional litigation, and public policy generally favors enforcing arbitration provisions in commercial contracts.
The two most common disputes are whether the disability trigger has actually been met and how the business should be valued. For medical disputes, the contract should specify a clear process for an independent medical examination. For valuation disputes, a well-tested approach is to have each side hire an appraiser, then have those two appraisers select a third neutral appraiser to break any tie. The more specific the procedures are in the original agreement, the less room there is for expensive arguments later.